Recovering for a recession and

some possible problems

These are experiences from 1929 and
1970 crisis
• To recover from a recession there needs to be either a rise in AD or a
readjustment in prices and wages.

• Classical economists argue that a recession will only be temporary

because labour and product markets are flexible. However
Keynesians argue that wage and price rigidity can keep the economy
below full capacity for a long time.

• For example to regain equilibrium it may be necessary to reduce

prices and therefore reduce nominal wages by an equivalent
amount. However this may be difficult because trades unions will
resist cuts in nominal wages, also firms would not be willing to cut
wages because it may lead to lower productivity amongst workers.
Resistance to recovery from a recession
• Low Consumer confidence
• Ineffectiveness of Monetary Policy
• Effectiveness of Fiscal Policy
• Deflation
• Hysteresis
• Supply side shocks
 Low Consumer confidence

• In a recession there will be rising unemployment and

therefore a fall in consumer confidence. This will cause
a rise in the savings ratio. In other words, people will
spend less of their disposable income and save more
leading to a bigger fall in AD. If confidence remains
very low for a long time then it will be difficult for the
govt to increase AD. For example, if the govt cut
income taxes this would increase disposable income,
but if confidence was low people would not be willing
to spend any extra and the economy would remain in a
recession.
 Ineffectiveness of Monetary Policy

• In a recession the Central Bank could cut

interest rates to stimulate demand. Lower
interest rates reduce the cost of borrowing
and therefore people should be more willing
to spend and invest. However, Monetary
policy could be ineffective. Firstly, firms may
be reluctant to invest, even though it is cheap
to borrow because they cannot see any
increase in demand.
 Effectiveness of Fiscal Policy
• Keynesians argue that expansionary fiscal policy can be used to
increase AD and get the economy out of a recession. However,
there may be many problems of using fiscal policy to increase
AD.

• Firstly there will be time lags. It takes time for the govt to
change its spending plans and once implemented it will take
time for this spending plan to actually increase AD
• Also increasing AD may cause crowding out. This means that if
the govt increases its spending then it will lead to a
corresponding fall in private sector spending. This is because
the govt borrows off the private sector to finance its spending.
Crowding out of private sector spending
 Deflation

• If there is deflation this makes it difficult to

increase demand. This is because people will not
spend if they feel that prices will be cheaper in
the future. Also, Monetary policy will become
ineffective because interest rates cannot fall
below 0% therefore with deflation real interest
rates may remain high. E.g. Japan has
experienced deflation during the 1990s and this
made it very difficult to increase AD and
economic growth.
 Hysteresis
• This states that what has happened in the past will affect
the future. For example if unemployment is high then it is
likely to continue being high. If people are unemployed for
a long time they become de-motivated and less employable
because they are now less skilled (less on the job training).
Also if productive capacity is not used for a long time then it
firms will shut factories down completely, causing a fall in
AS. Therefore in a prolonged recession there will be not just
a fall in AD but also a fall in AS causing a permanent fall in
the potential output of an economy. This occurred during
the Great depression of the 1930s
 Supply side shocks
• If there was a fall in AS as well as AD this
would make the recession more severe. For
example if there was a rapid rise in the oil
price like in the 1970s then AS would shift to
the left causing lower growth and higher
inflation